 GUIDED BY:  PRESENTED BY:

 MRS. RAJNI MAM  NEHA SHARMA

 30/15
I. CLASSICAL THEORY
II. CLASSICAL THEORY VS. KEYNESIAN
III. KEYNESIAN THEORY
IV. DETERMINATION OF EMPLOYMENT
V. DETERMINATION OF INCOME AND OUTPUT
VI. ACHIEVMENT OF FULL EMPLOYMENT
VII. KEYNESIAN MODEL
VIII. CRITICISM OF KEYNESIAN THEORY
 Two important theories of income and
employments are :
 1. Classical Theory of Income and
Employment,
 2. Keynesian Theory of Income and
Employment!
 The theory is ascribed to early Classical
economists like Adam Smith, Ricardo, and
Malthus and neo-classical like Marshall, Pigou
and Robbins. They believe that;
 An economy, as a whole, always functions at the
level of full employment i.e., full employment of
labour and other resources .
 Full employment level of output of goods and
services is the largest output that the economy is
capable of producing when all its resources are
fully employed. Full employment is regarded as a
normal situation
 , yet there could be a temporary
unemployment , it must be a temporary one
and it will be cured automatically through
free play of economic forces either by
government or private monoply itself.
 Classical behave that aggregate supply would
always be at full employment level which is
based on two assumptions,
 1) Law of Market and 2) Wage-price
flexibility explained above:
 Classical theory of employment is based on ‘ Law
of market’ which states that ‘supply creates its
own demand’. This implies that supply creates a
matching demand for it with the result that the
whole of output is sold out. So, there is no
deficiency in aggregate demand and hence no
possibility of over-production and
unemployment. Thus, equilibrium level of income
and employment is established only at the level
of full employment.
 (a) Price mechanism automatically brings
equilibrium between demand and supply in
the market,
 (b) Flexibility of interest rates brings about
equality between savings and investment,
 (c) Flexibility of wage rates brings about full
employment equilibrium. As a result, the
aggregate supply is always at full
employment level of output.
I. According to classical economists, money is
demanded for transaction motive alone. On
the contrary, keynes maintained that money is
demanded for transaction motive as well as
speculative motive .
II. According to classical economists, supply of
labourers depends on real wage (W/P). On the
contrary keynes believes that it depends on
money wage.
III. In classical theory saving is a function of rate
of interest and keynes is of view the saving is a
function of an income.
 During the Great Depression of the 1930s,
existing economic theory was unable either
to explain the causes of the severe worldwide
economic collapse or to provide an adequate
public policy solution to remove
unemployment.
 According to lord keynes, full employment is not
a normal feature of a developed capitalist
economy, there can be unemployment in every
economy.
 The main reason for this unemployment is
deficiency of aggregate demand.
 Unemployment can be removed by increasing the
aggregate demand.
 Many countries like: America, france etc adopted
all such measures failed to remove
unemployment as were recommended by
classical theory of unemployment,ie reduction of
money-wage, fall in rate of interest etc.
 Aggregate supply refers to the schedule
showing aggregate supply received at
different levels of employment. Aggregate
supply price received to the total amount that
all the producers must receive by selling the
output produced at a given level of
employment.
 Aggregate demand refers to a schedule
showing aggregate demand price received at
different level of employment.

C I AD
 Lord keynes analyzed deeply the problem of
unemployment and concluded that main
cause of unemployment was deficiency of
effective demand. Effective demand refers to
that level of aggregate demand where it is
equal to aggregate supply. He therefore
suggested that unemployment could be
removed by increasing the effective demand.
 According to him aggregate demand
comprised of demand for two type of goods:

Demand for consumption goods

Demand for investment goods

 Lord keynes was of the opinion that to
remove unemployment and to achieve full
employment , government interfernce in the
economy is imperative. Prior to lord keynes,
famous classical economist Malthus had also
opined that the main cause of fall in
employment was deficiency of effective
demand. But Malthus could not explain the
reason behind deficiency of effective demand.
•Short period

•Closed economy

•Labour is the only factor of production

•Under-employment equilibrium

•Saving and investment function

•Labour has a money illusion

 The basic concept of keynesion theory is that
level of employment in a country is determined
by the aggregate demand and aggregate supply.
Effective demand refers to that level of aggregate
demand at which it is equal to aggregate supply.
 Example: by employing one lakh labourer in a
country at any given time the aggregate supply is
worth rs 100 cr. And the aggregate demand at
the very time period is also rs 100 cr, then in that
situation aggregate demand price will be equal to
aggregate supply price.
 Y=f(N)
•National income or output (Y) is a
function(F) OF level of employment (N)

N=F(ED)
•Level of employment (N) is a function of
effective demand(ED)

•Effective demand(ED) expresses equality

ED (AD=AS) between aggregate demand and aggregate

supply
 Consumption expenditure is an important
constituent of aggregate demand. Increase in
consumption expenditure leads to increase in
total income. Consumption expenditure
depends mainly on 2 factors:

_ propensity to consume
_ national income
 It refers to that expenditure which leads to
addition in the total stock of capital assets. It
is an important constituent of aggregate
demand. According to keynes, investment
mainly depends upon 2 factors:

 - rate of interest
 - marginal effeciency of capital
 Under perfect competition, employment will be
determined at that level of aggregate demand at
which is equal to aggregate supply. This level is
called equilibrium level or effective demand.
According to keynes, “ the volume of
employment is given by the point of intersection
between the aggregate demand function and
aggregate supply function”.
 in short period aggregate supply remains
constant, as such, effective demand and level of
employment can be increased by changing
aggregate demand.
in a closed economy, aggregate demand depends upon:

1 2 3

• consumption • National • Propensity to

income consume
 Propensity to consume is the ratio of
consumption expenditure to different value of
income.
 National income depends upon consumption
based on the subjective and objective factors
which remain constant in the short period. It is
therefore not possible to increase consumption
in the short period.
 Investment the other determinant of a aggregate
depend is investment. It depends upon the:
-rate of interest
- marginal efficiency of capital.
Rate of interest is determined by the interaction
of the demand for and supply of money. Demand
for money is reflected in liquidity preference ie.
Preference to hold the wealth is called liquidity
preference. People hold their wealth in liquid
form for three motives: (1) transaction motive
(2) precautionary motive
(3) speculative motive
Demand for cash for transaction and precautionary
motives depend upon the level of income while
that for speculative motive depends upon the
rate of interest.
 At the high rate of interest people will be willing
to give more money on loan and at low rate of
interest they will send less.
 Marginal efficiency of capital refers to rate of
profit. It is governed by two factors 1) supply
price of capital asset and 2) prospective yield.
 An entrepreneur compares rate of interest with
marginal efficiency of capital before making
investment.
 Where MEC> Rate of interest , investment is
made otherwise not if MEC< Rate of interest no
investment is made. In short period investment
can be made by lowering the rate if interest.
 SO To increase the aggregate demand there
should be an increase in consumption and
investment. In short period consumption
cannot be increased but investment can be
increased so employment will increase.
Employment( aggregate Aggregate Trends in
N) supply( rs. demand ( rs. employment
( in lakh) Crore) Crore)
o 0 60 rise
10 60 100 rise
20 90 120 Rise
30 120 140 Rise
40 150 160 Rise
50 180 180 Equilibrium
60 210 190 Fall
70 240 200 fall
 In an economy even with unemployment and
achieving full employment it is essential to
increase aggregate demand, it is an under-
employment equilibrium.
 WHERE,
 Y= INCOME
 C= CONSUMPTION
 C0= AUTONOMOUS CONSUMPTION
 b= MARGINAL PROPENSITY TO CONSUME
 Y= INCOME IN INTIAL STAGE
 I= AUTONOMOUS INVESTMENT
 Y=f(N) , (OUTPUT (y) is the direct
function of employment (N), OUTPUT depends on
employment. Total output with increase in
employment.)
 NS=f(W), (Supply of labour (NS) IS
the direct function of money wage(W). It means
supply of labour increases with increase in
money wages.)
 ND = f(W/P) , (Demand for
labour (ND) is the inverse function of real
wage(W/P). It means demand for labour increases
as his real wage falls and decreases as his real
wage rises. Hence according to keynes, increase
in employment will lead to fall in real wages.)
 Labour market will be in equilibrium when demand
for labour is equal to its supply,
NS=ND
According to keynes, money market will be in
equilibrium when demand for money is equal to
supply of money, ie
MS= MD
 KEYNES believed that MD=L1(Y) +L2(r)
 I = S, KEYNES also assumed that in equilibrium,
investment and saving will be equal.
 I= f(r) , investment is an inverse function of rate
of interest ( r )
 S=f ( Y ) , saving is a direct function (f ) of
income. Saving increases with increase in income.
 These equations tell that to increase
employment in the short run, rate of interest
should be lowered and to increase demand
for labour, real wages should also be lowered.
For this purpose, price- level should be
raised and money wages not to be changed.
 The concept of equilibrium is self-
contradictory
 Keynesian economics is mainly static
 It has ignored the long period equilibrium
 Unrealistic assumption of perfect competition
 Keynesian theory is not a general theory
 Based on the assumption of closed economy
 Keynesian analysis is not so empirical
 It ignores the cost-push inflation.
 www.investopedia.com
 http://www.economicsdiscussion.net/theori
es/two-important-theories-of-income-
and-employment-micro-economics/687
 Principals of economics